January 2003

Portfolio Comments

Market View

Dorato Services

The Library: articles by Steve TeSelle

2003 Forecast

Portfolio Comments

I saw a headline the other day about how the old rules of investing don't apply anymore. The ensuing story wasn't helpful, but the headline got me thinking about the difference between conventional wisdom and rules. Conventional wisdom tends to change over time, but useful investment rules should be immutable. Let me give you some examples.

If one of your rules is to buy stocks whenever the Federal Reserve lowers interest rates, you're probably a little frustrated. Since the Federal Reserve started to lower rates in January 2001, the S&P500 has fallen about 30%.

Another rule that hasn't worked too well is to buy utility stocks for safety. With a messy deregulation process, a slow economy, and Enron, the prices of many of these once-safe stocks have fluctuated like Spring temperatures.

In fact, I don't think these rules are rules at all. They're more like patterns, and the factors that affect the patterns can change with time. In contrast, true investing rules should be as constant as a scientific formula.

My three basic rules of investing are to stay diversified, minimize costs, and minimize taxes. Diversification is never a bad idea, as you've read in my writing ad nauseum. And if you keep your costs and taxes low, your returns should be higher than if you don't. How's that for stating the obvious?

These rules aren't exciting, but I don't expect them to change from week to week, or from generation to generation.

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 Market View

Here we are at the end of 2002, with the major indices down for the third year in a row. The S&P500 is 40% off its high of April 2000, the Nasdaq is more than 70% off its high. Not too many people forecast that kind of performance back in 1999. I thought technology stocks were too expensive at the end of 1999, but I wouldn't have said they should drop 70%. Some of the financial press is fond of reviewing the past as though it were obvious to all but the most thick-headed. But of course, seeing into the future is more like peering into thick soup. Take all forecasts, including mine, with a spoonful of skepticism.

Stocks are up about 15% from their early October lows. Technology stocks have been racing. The Nasdaq is up nearly 40% since early October. These kinds of price swings have happened before. From October 1929 through 1932, the US stock market lost 80-90% of its value. In 1933, the market rose more than 50%. Volatility continued throughout the 1930s [Ibbotson]. Given the similarities of the technology and telecommunication stocks of the 1990s with the stock market of the 1920s, I would not be surprised to see a repeat of the 1930s volatility within the technology and telecommunications sectors. I expect other sectors to be subject to price swings as well, just on a smaller scale.

The US stock market still looks quite reasonably priced. The Value Line average price to earnings ratio for the 1700 stocks it follows hovers around 16 - in line with the long-term average.

The bond market continues to do the opposite of the stock market. As stocks have recovered since early October, bonds have dropped, especially US government issues. If inflation rears it's ugly head, and people lose faith in the Federal Reserve's ability to combat it, both bonds and stocks would suffer. But right now, that scenario seems unlikely.

From the bogeyman of recession, we've moved to the specter of deflation. You might think that falling prices are good: we can all afford to buy more. The problem is that falling prices throughout an economy can send that economy into a death spiral of falling demand (recession) and higher unemployment. If you owe money, you really hate deflation because while everything else is shrinking, including your assets, your debt stays the same. Yuck. In fact, if you don't have investments and you owe money, you'd rather see a healthy dollop of inflation because your debts will shrink relative to dollars you'll earn in the future. I don't think the risk of deflation is zero, but I think the Federal Reserve is aware of the potential problem and has some tools to fight it. I put the risk of deflation as only slightly more likely than Congress taking a pay cut.

The US economy is growing, though most folks aren't talking about it. Growth is uneven from quarter to quarter, but output is about 3% higher than last year. Unemployment is up to 6%, but that is still relatively low. Up until the late 1990s, many economists thought we couldn't go much below 6% without igniting inflation. A war with Iraq, a terrorist attack, or some other awful event could deal a nasty blow, but on balance, the US economy is recovering and in reasonably good shape.

The economy may be recovering, but airlines aren't. United Airlines finally declared bankruptcy in December. This is only the beginning of significant change in the US airline industry. We could see more bankruptcies, or companies may be able to avoid that option if workers and management can agree on cost cuts. Given the uncertainty, buying an airline stock right now is more like gambling than investing.

As always, I recommend investors stick to their long-term asset allocation strategies and retain a diversified stock portfolio.

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The Library: articles by Steve TeSelle:

• College Savings Options
• Retirement: What's the Target?
• Fun Facts About Taxes
• Understanding Your Finances
• Risk, Anyone?
• A Primer on Asset Allocation
• Debt, Friend or Foe?
• Life Insurance Basics
• Calculating a Return

  To read them online, simply click on the title. To obtain a printed copy, please call us at 303-733-4999, or e-mail me at steselle@doratocapital.com.

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  2003 Forecast

  An Insight Into Dorato’s Investment Style

  I don't claim to have special forecasting powers. If I ever do begin to feel that way, I promise to go lie down and wait until the feeling passes. No, the idea here is to compare the expected returns of several types of investments in order to set a reasonable asset allocation.

  I'll start with stocks. Based on a Price to Earning (P/E) ratio of about 16, stocks seem to be fairly priced. This fair pricing implies an expected return to stocks in line with the long-term average - about 10%. Of course, as always with stock returns, there is a big chance that we won't pin the 10% tail on the donkey. But given the negative returns of the last three years for the major indices, the chances are pretty good for positive returns.

  Foreign stock markets are difficult for me to judge. My guess is that they have a similar expected return to the US market at this point. You'll hear people say that European markets have lower P/E ratios than the US, but that's because investors expect slower growth in Europe than in the US. I don't have any justification for saying investors are wrong, so I expect about 10% annual returns from developed foreign markets, with a little boost if the dollar weakens. There may be higher potential returns in specific countries, say Russia, but these potential returns carry a lot of risk.

  Bonds, as usual, have a lower expected return. For 2003, I expect an even lower than average return for US Treasury bonds. Given the current 4% yield on 10-year Treasury notes and the likelihood that the Federal Reserve will raise rather than lower rates in 2003, the expected return for intermediate-term US debt is only 3-4%. Over the last several years, investors have been getting 8-10%; I think those happy days are over for a while.

  Corporate debt has a higher expected return than US government debt. For intermediate term debt of highly-rated companies, about 10-year maturity (5-year duration), the current yield is 5-6%. Assuming no major moves in inflation and no major deterioration in the economy, the expected annual return should also be 5-6%. The worst case for corporate bonds is rising inflation and a shrinking economy. I don't expect either of these, so corporate debt should perform better than US debt.

  Tax-exempt state and local debt yields around 3-4% for intermediate-term debt. States are struggling with budget woes, but I don't expect any state defaults. Local jurisdictions are also struggling and tend to have fewer resources than state governments. Therefore, the yield on local debt should be a little higher than the yield on state debt.

  Real estate, whether owned directly or through an investment trust (REIT), has performed well until just recently. I don't expect much price appreciation in the next year or two. Some REITs carry dividend yields of 7-8%, which I expect to be the sole source of return. So my expected return for real estate that includes a dividend is about 8%.

  For asset allocation, stocks hold the key to long-term growth. To keep up with inflation, especially inflation in areas such as health care that might not show up in official figures, investors should maintain at least 40-50% of their portfolios in stocks. To provide income and diversification benefits, investors can add bonds or real estate. Corporate bonds have much better return potential than US government debt.

  
  Sources: Economist, Value Line.

  

  "For 2003, I see another El Nino phenomenon, which will result in a larger than normal fish catch in the western hemisphere...Either that, or my kids swapped my crystal ball for the fishbowl again."
  

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